The Modern 1930's

The Daily Reckoning PRESENTS: It has become generally accepted that the bursting housing bubble will have its consequences – but do we fully understand the effect it will have on the average cash-strapped American consumer? Tom Au shows how the nation’s latest Ponzi scheme could bring about pullback in living standards not seen since the Great Depression. Read on…


Richard Suttmeier on Real Money hit the nail on the head when he said yesterday. that the real estate explosion is about to implode. Like him, I believe that the subprime lending collapse is not just a speed bump in the “New Economy.” Instead, it is a sign of wider problems in mortgage lending that threaten the viability of the New Economy itself. That’s because the collapse of the housing bubble means that a major “band-aid” has been ripped off the country’s Achilles heel, the cash-strapped, savings short American consumer, exposing the scab underneath.

Who would have thought it would come to this? For three decades after World War II, the average American worker’s income grew by 2-3% a year after inflation, and stateside consumer spending grew apace. But after the mid-1970s, these income gains slowed to a crawl, while spending growth continued at the same pace. But Baby Boomers felt that the 2%-3% average annual real income growth enjoyed by their parents was their birthright. And when they didn’t get it, they settled for “the next best thing,” 2%-3% average annual spending growth financed by artificial means. The result is that the average American is now spending at a level not sustainable by income, but only by asset values, specifically in real estate. And when those asset values collapse, and they’re doing so as we speak, so will U.S. consumer spending and overall economic growth.

But that can’t be so, some might say. The country is much wealthier today than in the 1970s, which would support much higher consumer spending. That much may be true for the country as a whole, but it’s not for the whole country by any means. The reason is that while (President) John F. Kennedy’s “rising tide lifted all boats” through the 1960s, most of the gains since then have accrued to the top 20% of the population. For instance, as late as 1980, the average CEO made only about 40 times as much as the average worker, now it’s more like 400 times. On the other hand, antipoverty programs and removal of lingering discrimination have greatly reduced the number of the truly poor. So the person in top decile (90th percentile and higher) of the economic ladder (where subscribers are overrepresented), is decidedly better off than the equivalent thirty years ago, and someone in the bottom decile (10th  percentile and lower) is somewhat better off. But the average person (the one at the 50th percentile, and 30 percentiles on either side) is the one who has gained very little real income in the past three decades. Nevertheless, it has been in the interest of U.S. economic policy to pacify this person by allowing him/her to maintain spending growth at historical (post World War II) levels, even though income growth hadn’t been keeping up.

The housing bubble was a good a tool as any for this purpose. At first the gap was plugged by reduced savings. But as savings rates plummeted in the 1980s, this fuel could not last for long. So credit card debt took up the slack. But that soon played out, especially when the deduction for credit card interest (but not mortgage interest) was removed in the 1986 tax reform. The ray of hope was the fact that interest rates were falling through the 1980s, and periodic refinancings meant that homeowners could save money by capturing progressively lower rates on their mortgages, and using the difference for spending. What’s more, interest on this mortgage-related spending could qualify for the tax deduction denied credit card interest.

But if falling interest rates meant that constant mortgages required progressively lower monthly payments, they also meant that a homeowner could choose to “invest” by maintaining constant payments, taking out larger mortgages, and buying more house. And if a synchronized housing boom was underway, or at least could be orchestrated, many might be persuaded to do so. And so it was done, which is why housing values doubled in real terms between 1996-2006, an unprecedented rise in American history. Now the consumer had a house (or two) that could also double as an ATM, i.e., the best of both worlds (a framework that could serve as both a place to live, and a source of “income” for other consumer spending).  Using this twisted logic, going over one’s head (taking out a mortgage that consumed 50% or more of income) was a smart thing to do because it meant a more valuable asset and more spendable income down the line.

Thus housing became the nation’s latest Ponzi scheme, one that could work only if more and more people were sucked into it. But even if the housing market was on fire, as it was in the past decade, it needed firewood to burn. And if there was a growing shortage of “firewood,” to feed this boom, there was always “kindling” (soft materials such as leaves and hay that burn for only a short period of time), in the form of such monstrosities as interest only and negative amortization loans to subprime borrowers. From a financial point of view, however, such borrowers were placed in the position analogous to “tearing down their (financial) house for firewood” (pun intended), i.e. being forced create a problem of less house for tomorrow because today’s problem of freezing to death was so severe.

The collapse of the housing bubble is bringing about an end to this game, and will soon face average American consumers with the fact that their consumption standards of the mid-2000s, were way out of whack with income levels that had reached only a mid-1980s trendline (given perhaps ten, not thirty, iterations of 2%-3% growth off the mid-1970s base). To bring income and consumption back into balance, average Americans will have to fall back two decades in terms of standard of living, which would still put them back at Western European levels of today. But such a pullback would represent “the modern 1930s.”

That’s because the original 1930s took American consumption back to 1910s levels, which then represented “prosperity” by prevailing global standards. But that was a big comedown for an American public that had just experienced the 1920s, which gave a glimpse of a prosperity that would be experienced in the 1950s by their children, but not by themselves.

Likewise, the Internet Boom of the 1990s gave adult Americans of the time a glimpse of the world that their children will inherit for their middle age – in the 2020s – as the Boomers get ready to shuffle off this mortal coil. Like the peers of Moses, who saw the Promised Land but never got to enter it, Americans will wander the desert for two generations until their children are ready to take the big step. (And yes, I believe that those children will fight the modern “battle of Jericho” to get there.) But getting from here to there will not be a pleasant experience.


Tom Au, CFA
for The Daily Reckoning
April 25, 2007

P.S. Not only is the most dramatic property asset bubble of modern times clearly over… but the slip in real estate prices we’ve seen so far is not even close to being the beginning of the real devastation to come… not just in property, or even Wall Street, but across the entire U.S. economy, now and for at least the next three-four years, if not longer.

Editor’s Note: Thomas P. Au, CFA, is a principal with R. W. Wentworth, a financial services firm in New York City. Earlier he was an emerging markets portfolio manager for the investment arm of Cigna Corp. and an analyst with Unifund, S.A. of Switzerland and Value Line. He graduated cum laude with a B.A. in Economics and History from Yale University and an M.B.A. in Finance from New York University. Mr. Au is the author of “A Modern Approach to Graham and Dodd Investing.”

“The Spanish property market is collapsing!” announced colleague Merryn Somerset Webb this morning.

Our American readers will wonder what the heck Spanish property has to do with them. Ms. Webb explained:

“Only three countries in the world have a serious subprime problem – the U.S., Britain…and Spain. But no country has taken more advantage of low interest rates to build more houses and sell them at prices they don’t deserve to more people who can’t afford them. They just built too many new houses…

“One building company had gone up 1,000% since it listed only a few months ago. It got whacked yesterday…so did the other builders.”

Today our question is, “How much is too much?”

Many people thought you couldn’t build too many holiday homes in Spain…just as you couldn’t build too many hotel rooms in Las Vegas…or pay too much for Chinese stocks…or pay too much to hedge fund managers…or have too much money in private equity…or too many dollars at large in the world financial system.

Since the expression ‘too much’ has been extant in the English language for a very long time, we assume it must mean something. What we’ve been waiting…and waiting…and waiting…to find out is what it means in financial affairs.

The latest figures show that hedge fund manager Jim Simons earned $1.7 billion last year. Is that too much? He takes an unbelievable 5% of his clients’ assets each year, in payment for his services – plus, and even more unbelievable, 44% of profit. Is that too much?

Readers will remark that his $6 billion Medallion fund rose 84% last year (Simons is good with figures). Investors came out ahead more than 40% even after paying the outrageous fees.

Or what about Ed Lampert or Kenneth Griffin, each of whom also earned more than $1 billion last year. Was that too much? We don’t know. But we came back from our vacation, opened our eyes, and thought we saw ‘too much’ everywhere we looked.

Money streams into new investment funds. Even Brian Hunter, who lost $6 billion trading energy for Amaranth, is starting up a new fund. And John Arnold, formerly of the Enron energy-trading desk, earned more than $240 million last year – partly by taking the other side of Hunter’s trades.

Over on the Las Vegas Strip, Goldman Sachs (NYSE:GS) is buying Carl Icahn’s four casinos…for $1.3 billion. Is that too much? Again, we don’t know; but when it comes to excess, what Las Vegas doesn’t already know probably isn’t worth knowing. The place had a total of 35,000 hotel rooms in the 1970s, which seemed like too many to us. Now, it has five times as many – 151,000 – which seems like more than enough.

But ‘too much’ has dropped from the English vocabulary in Nevada…and perhaps the rest of the world, too. The Venetian alone is adding 3,200 new rooms. And over at the old Stardust Casino, the owners judged it too small, so they blew the place up last month…to build a new development, Echelon Place, with more than 5,000 rooms.

Meanwhile, MGM is spending $7 billion putting up the City Center development – the most expensive development in Las Vegas history. Isn’t that a little too much, dear reader?

Who knows? All we know is that throughout the world, a great boom is on.

And if you want to count the hotel rooms for yourself, attend this year’s FreedomFest in Vegas. The three-day event will be taking place at the Bally’s/Paris resort July 4-7 and will include an intensive investment seminar by some of your favorite DR faces. Learn more by calling Tami Holland, Conference Coordinator, 1-866-266-5101; or go to

More news:


Chris Gaffney, reporting from the EverBank world currency trading desk in St. Louis…

“The strong housing industry and bubble in housing prices was what kept the U.S. economy growing over the past few years, so a reversal in this industry will have to have an offsetting negative impact on our economy.”

For the rest of this story, and for more market insights, see today’s issue of The Daily Pfenning


And more thoughts…

*** The Shanghai stock market has gone up 37% so far this year. The Chinese cache of dollars has soared; at the present rate, China should add another half a trillion to its reserves this year. Everyone seems to want to own a Chinese bank…recent Chinese bank IPOs found buyers willing to pay twice the P/Es of other large banks in developed countries – despite the fact that Chinese banks offer investors notoriously vague, ambiguous and confusing information on their activities. Still, investors rush to get in before they blow up.

The Dow hit a new record high yesterday – just shy of 13,000. Is that too much?

It was too much for us before it got to 10,000. Have we simply missed an opportunity? Or was the opportunity too risky for a prudent investor? And is it too risky now to buy into the Las Vegas boom?

Again, we don’t know. We don’t know how much is too much. But unlike most investors, we’re convinced that ‘too much’ is out there somewhere; and it may be behind us.

*** The American Century began in the beginning of the 1900’s, when the United States passed Great Britain to become the world’s number one economy, and the U.S. capital market grew to be the largest on the planet. Germany was hard on America’s heels, then, although the Teutonic competition – along with the rest of Europe – was buried in the trenches of World War I. That left the United States as undisputed numero uno.

Toyota (NYSE:TM) surpassed General Motors (NYSE:GM) in worldwide sales in the first quarter…after GM had dominated the world auto market since it passed Ford in 1931.

But last month, still early in the 21st century, another milestone was passed. European capital markets – including Russia – are now bigger than the U.S. capital market. “We may no longer be living in the American century,” writes Simon Pickard.

No, dear reader, it’s probably not the American Century. Other economies are growing faster. Other peoples are saving more money. Other businessmen are making better investments. And other workers are earning more money.

It’s a very big and competitive world – and you don’t win in a competitive world by kicking back. In athletics, you don’t win by lounging in front of a TV; you win by training rigorously. In money matters, you don’t win by throwing around the stuff; you win by rigorously saving, working, and investing.

In China, they build factories. In America, we build casinos and hotel rooms. In China, people save 25% of their piddling incomes. In America, net savings rates are near zero – on the largest incomes in the world. In China, foreign reserves increase by more than $1 billion per day. In the United States, net outflows to foreigners exceed $2 billion per day.

Americans work hard…but how much of this work is actually done in industries that make people wealthier? Americans invest…but how much of the investment goes into productive industry?

This is why, as far as investment strategies go, we tend to steer toward Chris Mayer’s ‘tangible assets that sweat’ line of thought.

“Tangible assets are simply things we can touch and feel, things we can see and count,” Chris reminds us. “These investments include things like buildings, timber, cash, certain machinery, land, vineyards and other unique assets. Industries that are not going away and that are in no danger of the next generation of competitors making them obsolete.

“Contrast this with the most exciting and best-loved investments of the tech boom years. Companies like AOL, Lucent, JDS Uniphase and a host of others that carried billions of dollars in intangible assets on their books – such as ‘capitalized software development costs’ or ‘goodwill,’ among others.

“These assets were on the books because accounting conventions required it, not because they represented value that could be sold or accessed in any direct way. Most of these assets were subsequently written down, leading to billions of dollars in losses for those companies and their shareholders as well.

“Tangible assets seldom lose value like that. Most of the time an asset like timber or unique real estate only become more valuable as time goes on. That’s the general idea – I like to be involved in companies where time works in my favor and where the principal assets of the company are things I can touch and feel, that I can count and see.”

Chris has recently added industrial pipe manufacturers, sugar havesters, obscure shipping lines – even a chicken harvester to his Capital & Crisis portfolio. Granted these stocks are nowhere near as exciting as investing in a big name company with favorable earnings reports…but what many investors don’t realize is that earnings can be very deceptive (we think Enron proved that pretty well.)

“Cash flow is the sweat, the streams of actual cash that a company generates,” says Chris.

“Cash flow gives companies options to pursue wealth-generating strategies, to reinvest in the business for future growth, to pay dividends or buy back stock, or to make smart acquisitions. Cash flow means that a company has options.”

What do you think, dear reader? If this is another American century, what kind of century will it be?


The Daily Reckoning